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McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Economics and EconomicEconomics and EconomicReasoningReasoning

Chapter 1


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Laugher CurveLaugher Curve Q. Why did God create economists?

A. In order to make weather forecasterslook good.


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What Economics IsWhat Economics Is Economics is the study of how human

beings coordinate their wants and desires,

given the decision-making mechanisms,

social customs, and political realities of the

society.


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What Economics IsWhat Economics Is One of the key words in the definition is

coordination.


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What Economics IsWhat Economics IsAny economic system must solve three

central coordination problems:

What, and how much, to produce.

How to produce it.

For whom to produce it.


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What Economics IsWhat Economics Is Scarcityexists because individuals want

more than can be produced.

Scarcity the goods available are too fewto satisfy individuals desires.


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What Economics IsWhat Economics Is The degree of scarcity is constantly

changing.

The quantity of goods, services, and

usable resources depends on

technology and human action.


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What Economics IsWhat Economics Is Economics is the study of how to get

people to do things they're not wild about

doing and not to do things they are wild

about doing.


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What Economics IsWhat Economics Is To understand the economy, you need to

learn:

Economic reasoning.

Economic terminology.

Economic insights economists have about

issues, and theories that lead to thoseinsights.


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What Economics IsWhat Economics Is To understand the economy, you need to

learn:

Information about economic institutions.

Information about the economic policyoptions facing society today.


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AGuide to EconomicAGuide to Economic

ReasoningReasoning Economic reasoning is making decisions

by comparing costs and benefits.


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Marginal Costs andMarginalMarginal Costs andMarginal

BenefitsBenefits The relevant costs and benefits that matter

are the expected incremental, or

additional, costs incurred and the expectedincrementalbenefits of a decision.


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BenefitsBenefits Economist use the term marginalwhen

referring to additional or incremental.


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BenefitsBenefits Marginal cost the additional cost to you

over and above the costs you have already

incurred.

This means not counting sunk costs coststhat have already been incurred and cannot

be recovered.


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BenefitsBenefits Marginal benefit the additional benefit

above and beyond what youve already

accrued.


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BenefitsBenefitsAccording to the economics decision

rule:

If the relevant benefits of doing somethingexceed the relevant costs, do it.

If the relevant costs of doing something

exceed the relevant benefits, dont do it.


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Economics and PassionEconomics and Passion Economic reasoning is based on the

premise that everything has a cost.

It leads to a better society for the majority

of people.


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Opportunity Cost

Opportunity Cost

Opportunity costis the basis of

cost/benefit economic reasoning

It is the benefit foregone, or cost, of the

next-best alternative to the activity you

have chosen.


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Opportunity Cost

Opportunity Cost

In economic reasoning, opportunity cost

must be less than the benefit of what you

have chosen.


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Opportunity CostOpportunity Cost

Opportunity costs are not limited to

individual decisions but to government

decisions as well.


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Economics andMarket ForcesEconomics andMarket Forces

The opportunity cost concept applies to all

aspects of life.

It is fundamental to understanding how

society reacts to scarcity.


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When goods are scarce, they must be

rationed.

That means a mechanism must be chosento determine who gets what.


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Economic forces are the necessary

reactions to scarcity.


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A market force is an economic

circumstance that is given relatively free

rein by society to work through the market.


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Market forces ration by changing prices.

When there is a shortage, the price

goes up.

When there is a surplus, the price goes

down.


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Economic reality is controlled by three

forces:

Economic forces (the invisible hand).

Social and cultural forces.

Political and legal forces.


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The invisible handis the price

mechanism, the rise and fall of prices, that

guides our actions in a market.


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Social, cultural, and political forces play a

major role in deciding whether to allow

market forces to predominate.


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Political and social forces often work

together against the invisible hand.

Social and political forces are active in

all parts of your life.


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What happens in society can be seen as a

reaction to, and interaction of, economic

forces, political forces, social forces, andhistorical forces.


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Economic TerminologyEconomic Terminology

Youll need to learn economic terminology.

Hundreds of economic terms will be

introduced in this book.


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Economic InsightsEconomic Insights

General insights into how economies work

are often based on generalizations called

economic theories.


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Theory ties together economists

terminology and knowledge about

economic institutions and leads toeconomic insights.


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Economic theories are too abstract to

apply to specific cases.

A theory is often embodied in an economicmodel or an economic principle.


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Economic model a framework that

places the generalized insights of the

theory in a more specific contextual setting.


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Economicprinciple a commonly held

insight stated as a law or general

assumption.


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Economists cannot test their models with

controlled experiments.

It is impossible to hold other things

constant, as is done in laboratory

experiments.


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The Invisible Hand TheoryThe Invisible Hand Theory

Economist have come to the following

insight:

Price has a tendency to fall when the quantitysupplied is greater than the quantitydemanded.

Price has a tendency to rise when the quantitydemanded is greater than the quantitysupplied.


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The Invisible Hand TheoryThe Invisible Hand Theory

According to the invisible hand theory, a

market economy, through the price

mechanism, will allocate resourcesefficiently.

Efficiencymeans achieving a goal as

cheaply as possible.


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Economic Theory and StoriesEconomic Theory and Stories

Economic theory and its models are a

shorthand means of telling a story.

If you cant translate a theory into a story,

you dont understand the theory.


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Microeconomics andMicroeconomics and

MacroeconomicsMacroeconomics Economic theory is divided into two parts:

microeconomic theory and macroeconomic

theory.


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MicroeconomicsMicroeconomics

Microeconomics is the study of individual

choice, and how that choice is influenced

by economic forces.


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MicroeconomicsMicroeconomics

Microeconomics studies such things as:

The pricing policy of firms.

Households decisions on what to buy.

How markets allocate resources amongalternative ends.


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MacroeconomicsMacroeconomics

Macroeconomics is the study of the

economy as a whole.

It considers the problems of inflation,

unemployment, business cycles, and

economic growth.


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Economic InstitutionsEconomic Institutions

To apply economic theory to reality, youve

got to have a sense of economic

institutions. Economic institutions laws, common

practices, and organizations in a society thataffect the economy.


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Economic InstitutionsEconomic Institutions

Economic institutions differ significantly

among nations.

They sometimes seem to operate in

ways quite different than economic

theory predicts.


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Economic Policy OptionsEconomic Policy Options

To carry out economic policy effectively,

one must understand how the economic

policy might change institutions.


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Objective Policy AnalysisObjective Policy Analysis

Good objective policy analysis keeps the

value judgments separate from the

analysis.

Subjective policy analysis is that which

reflects the analysts view of how things

should be.


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To make clear the distinction between

objective and subjective analysis,

economics is divided into three categories: Positive economics

Normative economics

Art of economics


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Positive economics the study of what

is, and how the economy works.

Normative economics the study of

what the goals of the economy should

be.


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Art of economics the application of the

knowledge learned in positive economics

to achieve the goals determined innormative economics.


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Maintaining objectivity is easier in positive

economics harder in normative

economics.


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It is hardest to maintain objectivity in the art

of economics.

It embodies the problems of bothpositive and normative economics


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Policy and Social and PoliticalPolicy and Social and Political

ForcesForces The choice of policy options depends on

more than economic theory.

As soon as economists apply economy

theory to policy, political and social forces

must be taken into account.


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M G Hill/I i 2004 Th M G Hill C i I All Ri ht R d

Economics and EconomicEconomics and Economic

ReasoningReasoning

End of Chapter 1

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